Shareholder Centre

An end to the rising yuan?

China's major trading partners are likely to be deeply disturbed by signs Beijing intends to put an end to the yuan’s rise. But there's more than one explanation for its latest currency fix.

Is China about to put an end to the yuan’s rise?

That’s the speculation among foreign exchange traders after China reported a $31.5 billion trade deficit in February, much higher than analysts were expecting.

Even after allowing for the distortions caused by the week-long Lunar New Year holiday by combining the January and February trade figures, the numbers were far from reassuring. China’s exports and imports grew by only 6.9 per cent and 7.7 per cent per year on year, compared with 14.3 per cent and 20.7 per cent respectively in the final three months of 2011. As a result, the combined trade deficit in the two months came in at $US4.2 billion (compared with a deficit of $890 million in the first two months of 2011).

Chinese authorities have been quick to argue that the country’s growing trade deficit means that there’s no need for further sharp rises in the yuan. Last week Yi Gang, the deputy governor of the People’s Bank of China, told the National People’s Congress that the yuan had "never been closer to equilibrium”, while Chen Deming, China’s commerce minister, said the yuan had reached a "reasonable range”.

However, China’s major trading partners – the US and Europe – are likely to be deeply disturbed by signs that China intends to put an end to the yuan’s rise. They’ve long argued that China has been keeping its exchange rate undervalued, which has made its exports artificially cheap. Even though the yuan has risen by about 30 per cent against the US dollar since 2005, they believe the Chinese currency should rise further.

China’s currency manipulation is likely to be a flashpoint in the upcoming US presidential elections, because China continues to run huge trade surpluses with the United States. In the first two months of this year it ran a $26.2 billion surplus with the US, up from $21.5 billion in the same two months in 2011.

Although US president Barack Obama has resisted formally labelling China as a "currency manipulator”, Mitt Romney, the front-runner to become the Republican candidate, has indicated he will be quick to do so if he is elected.

In an interesting piece, Louis Gave, from the respected research group GaveKal, points out that China’s sluggish trade figures come on top of data which painted a somewhat disappointing picture of the Chinese economy in the first two months of the year, with industrial production and retail sales both decelerating, while loan growth was weaker than expected.

But, he notes, even more disappointing was the reaction of the Chinese central bank. It fixed the yuan/dollar exchange rate at 6.3282 on Monday, up 209 pips from Friday’s fix (an upward move means that the yuan is depreciating). As he notes, "this was one of the biggest depreciations in the daily fix in the past year and raises the obvious question: is the Politburo panicking in the face of weaker growth and trade and reacting with a return to tried-and-true weak-currency mercantilist ways?”

Gave argues that this is unlikely to be happening. He argues that although the move was large by recent standards, it wasn’t out of line with longer-term movements. Instead, Gave says that there are two other possible explanations for the PBoC’s move.

In the first place, it could be trying to inject some short-term volatility in the market in order to dissuade investors from believing that a rising yuan is a one-way bet. A second explanation is that the PBoC is starting to adjust to a world in which the US dollar is no longer structurally weak. With both the euro and yen now falling against the US dollar, China may be moving to adjust the value of its currency against a basket of currencies, rather than just the US dollar.

As Gave notes, "while this shift would in part be motivated by a desire to maintain Chinese export competitiveness, it is much less crassly mercantilist than a swift devaluation in response to bad trade data.”

However, Gave points out there could be implications for global markets if the Chinese yuan continues to depreciate. It could, he argues, "lead to a pullback in risk assets, because markets will be in doubt about the true intention of Chinese policy: vigorous mercantilism, tactical volatility or an adjustment to a strong-dollar world.”

He adds that "this is doubly true since risk assets have had a good run in the past few months and most sentiment indicators (put-to-call ratios, investor surveys, etc) seem to point to higher odds of a pullback.”

IMPORTANT: This information has been prepared without taking into account your objectives, financial situation or needs and you should consider if the information is appropriate for you before making an investment decision. Unless otherwise specifically stated or disclosed (such as the InvestSMART Diversified Portfolios Product Disclosure Statement), neither InvestSMART Financial Services Pty Ltd nor any of its Related Companies make any recommendations as to the merits of any investment opportunity referred to in its emails or its related websites. Product disclosure statements for financial products offered through InvestSMART can be downloaded from this website or obtained by contacting 1300 880 160. You should consider the product disclosure statement before making a decision about the product. All indications of performance returns are historical and can not be relied upon as an indicator for future performance.